Quiz 25: National and Global Choices: Floating Rates and the Alternatives

Business

In every country the fixed exchange rate is determined by the authorized monetary authority of the country. That authority is normally the central bank. Under this system, government interferes in needed times and a huge volume of foreign exchange reserve is required for this intention. When a country allows the exchange rate to be fixed then external balance can be easily achieved directly and at the same time it helps to achieve internal balance indirectly. Choosing an exchange rate policy to achieve both external and internal balance is very tough task for a country. Whatever, composite of all countries' choices makes the global exchange rate system. If we through eye to the history or trend of global exchange rate system then we see that initially gold standard, then adjustable pegged system, and then Bretton wood system was adopted iN20 th century. Now, countries follow either fixed or flexible global exchange rate system. If all the countries or many of them choose to follow fixed exchange rate system then it can expected clearly that global inflation volume would be quite lower. This is because under fixed exchange rate system internal shocks mainly monetary shocks become less disruptive; fiscal policy works effectively even if capital flows are sufficiently responsive to interest rates; it needs coordination of countries economic policies and objectives; relative constancy of exchange rates promote global trade and other transactions volume. All these demonstrations help the countries at their individual level to maintain almost same inflation rate. Therefore a discipline effect is seen in case of high inflation facing countries. Empirical data shows that in modern times most of the countries including rich and advanced countries are facing high inflation. So adhered to fixed exchange rate system by many countries would keep the global inflation volume in a low range. It ultimately can be said that the volume would be quite lower as compared to the flexible exchange rate system effects.

The floating exchange rate is determined under the free market conditions by the forces of demand and supply and no government interference exists there. When a country allows the exchange rate to float then the external balance can be easily achieved directly and at the same time, it helps to achieve internal balance indirectly. Choosing an exchange rate policy to achieve both external and internal balance is a very tough task for a country. If a country decides to follow a floating or flexible exchange rate system then it must be a clean float. This is because it is clear that under a floating or flexible exchange rate system determination of the exchange rate value of home currency is entirely based on market situations. The rate is thus adjusted to market fluctuations and shocks automatically. Thus, without government intervention, if misbalances are to be fixed then obviously float must be clean in principle. Moreover, under a fixed exchange rate system internal shocks mainly monetary shocks become less disruptive; fiscal policy works effectively even if capital flows are sufficiently responsive to interest rates; relative constancy of exchange rates promote global trade and another transaction volume. All these demonstrations help the countries at their level to maintain almost the same inflation rate. It means the flexible exchange rate system effects are quite serious comparatively than the fixed exchange rate system. So, in order to curb those situations created by external shocks then float must be clean no matter what.

The floating exchange rate is determined under the free market conditions by the forces of demand and supply and no government interference exists there. Due to its auto determination and adjustment nature floating exchange rate is a major subject of debating. Some economists believe that beyond short run floating exchange rate actually adversely affect the economy and so they worry about its effects. But some economists argue that there is no point to make this topic controversial because of its favourable effects and they are literally not worried about it. The floating exchange rate is variable by nature. Since recently the rate of its variability has been increased more. Some economists are literally not worried about it and so not showing any interest in it. But some economists are so much worried about it. Economists not worried or concerned about floating exchange rate argue that variability of floating exchange rate can offset inflation volume and adjust internal and external shocks which ultimately promote trade at global level. Inflation trend of world economy since 1980s reveals that all the countries facing high inflation with floating exchange rate are not confronting any serious economic issues. Basically older studies showed no major impacts on global trade for the variability of floating exchange rate. Economists worried about floating exchange rate argue that variability of floating exchange rate create serious economic effects within a fairly short run period normally few months or years. So, this is controversial and serious issue to worry. Modern time's studies show that the possible results from high of floating exchange rate are that the floating exchange rate risk decreases global trade volume directly in short run. Currency value or exchange rate risk can be hedged into different financial markets but empirical data shows that after all it affects trade volume. Mainly beyond short run it affects real investment volume on exportable products and increases its riskiness. This is because these types of investments are hard to be hedged.